Finance 101

Valuation Models

Misconceptions about Valuation

• Myth 1:

A valuation is an objective search for “true” value

– Truth 1.1: All valuations are biased. The only questions are how much and in which direction.

– Truth 1.2: The direction and magnitude of the bias in your valuation is directly proportional to who pays

you and how much you are paid.

• Myth 2.

A good valuation provides a precise estimate of value

– Truth 2.1: There are no precise valuations

– Truth 2.2: The payoff to valuation is greatest when valuation is least precise.

• Myth 3:

The more quantitative a model, the better the valuation

– Truth 3.1: One’s understanding of a valuation model is inversely proportional to the number of inputs

required for the model.

– Truth 3.2: Simpler valuation models do much better than complex ones.

Approaches to Valuation

Valuation Models

Asset Based

Valuation

Discounted Cashflow

Models

Relative Valuation

Liquidation

Value

Equity

Stable

Current

Sector

Two-stage

Three-s tage

or n-stage

Equity Valuation

Models

Normalized

Earnings

Book Revenues

Value

Sector

specific

Option to

expand

Dividends

Cost of capital

approach

APV

approach

Option to

liquidate

Young

firms

Undeveloped

land

Firm Valuation

Models

Patent

Free Cashflow

to Firm

Option to

delay

Firm

Market

Replacement

Cost

Contingent Claim

Models

Excess Return

Models

Undeveloped

Res erves

Equity in

troubled

firm

Basis for all valuation approaches

• The use of valuation models in investment

decisions (i.e., in decisions on which assets are

under valued and which are over valued) are

based upon

– a perception that markets are inefficient and make mistakes in assessing value

– an assumption about how and when these inefficiencies will get corrected

• In an efficient market, the market price is the

best estimate of value. The purpose of any

valuation model is then the...